COLUMN-China must get the price of gas right: John Kemp

By John Kemp

LONDON Jan 22 China is already the world's
fourth-largest gas consumer, but it will struggle to reach its
goal of doubling gas use to 260 billion cubic metres a year by
2015 unless a range of barriers can be overcome.

Lack of upstream investment is only one of many problems
facing China's gas industry. Getting the price right is more
important.

The government needs to find a pricing mechanism that will
encourage the costly development of domestic gas resources such
as shale, as well as an increase in imports, and pay for more
transmission and storage infrastructure. At the same time, gas
will need to undercut the price of coal as China aims to curb
pollution and greenhouse gas emissions.

UPSTREAM INVESTMENT

This week China announced the winners of a new round of
shale gas exploration licences, part of a bid to kick-start its
stalled domestic shale gas development programme.

The Ministry of Land and Resources (MLR) awarded licences
for 19 blocks to a total of 16 Chinese companies following an
auction held in October, according to a report published by the
official Xinhua news agency.

The auction appears designed to resolve some problems that
have slowed the development of the domestic shale industry,
which have left it far behind the target of 6.5 billion cubic
metres per year by 2015, set out in the government's 12th
Five-Year Plan.

Until now, most exploration licences have been allocated to
just three domestic companies: China National Petroleum Company
(CNPC), China National Offshore Oil Company (CNOOC)
and Sinopec.

These three represent the bulk of domestic production and
have formed an oligopoly in the upstream sector in terms of
licences, according to a report by the International Energy
Agency (IEA), with input from the National Energy Administration
of China's State Council ("Gas Pricing and Regulation",
September 2012).

Threshold exploration activity to keep the licences has been
low. Incumbents have been able to hoard licences and prevent
entry by competitors despite doing little drilling or surveying.
Smaller companies have few chances to acquire licences through
compulsory relinquishment, the IEA found.

"The involvement of foreign or smaller Chinese gas companies
is ... so far limited and happens mostly through partnerships
and joint ventures with the Big Three," which control the pace
of exploration, IEA explained ().

The IEA report contrasted the situation in China with more
competitive and open processes elsewhere: "In the United Kingdom
and Norway, companies that are not respecting their work
programme as agreed in the plans of development and operation
lose their licences, which can then be offered again to the
market through tenders."

Expert and rigorous monitoring by officials at the licensing
authority "incentivises companies to respect their work
commitments to keep their licences, rather than enabling them to
avoid competition by buying and holding licences indefinitely."

In China's latest auction in October, the winners included
six state-owned enterprises, eight companies backed by
provincial governments, and two private firms. Many are non-oil
firms, which could provide lucrative opportunities for oilfield
service companies such as Schlumberger and Halliburton
to become involved in exploration and field development.

MLR promised to supervise exploration efforts and punish
firms that fail to carry out the work promised in their licence
bids.

By awarding licences to a wider group of participants,
including companies with little or no oil or gas production, and
extracting promises from them to spend as much as $2 billion
over the next three years, MLR is trying to accelerate the rate
of drilling.

MARKET REGULATION

The IEA report identified a host of other problems holding
back the development of a large and competitive internal gas
market, most linked to regulation and pricing.

Responsibility for regulating the sector is split among the
National Energy Administration, the National Energy Commission,
the National Development and Reform Commission, the Ministry of
Land and Resources and a host of other bureaus in Beijing, while
provincial governments protect their own enterprises, and the
Big Three oil and gas companies have privileged access to the
regulatory process.

Unlike the U.S. Natural Gas Act, there is no single law
regulating production, imports, pipelines and storage.

Pipeline and transmission capacity remains low for a country
of China's size and mostly controlled by the Big Three, with
limited or no rights of third parties.

China has more than 50,000 kilometres of large-diameter
transmission lines, with more than 30,000 km controlled by CNPC.
The network is being rapidly built out. CNPC this week said a
gas pipeline from Myanmar will be fully operational by the end
of May.

But Germany has more than twice as much transmission
capacity for a smaller market (97 bcm) with a land area only 4
percent of China's. The United States, which has a comparable
land area, has 500,000 km of transmission pipelines, about ten
times as much as China, of which 70 percent are interstate
lines.

China has virtually no storage capacity for managing daily
and seasonal variations in demand. Working storage is just 1.9
bcm for a market that consumed 130 bcm in 2011. By comparison,
most European countries that rely on imports have storage
capacity amounting to around 20 percent of annual demand. At the
moment all working storage is controlled by CNPC. Local gas
distribution companies rely entirely on limited-capacity tanks.

PRICING MECHANISM

Distorted gas prices are the biggest obstacle of all. Prices
are not low. For residential customers, tariffs range from $7
per million British thermal units (mmBtu) in Chongqing to $9 in
Beijing and $11 in Shanghai. For industrial consumers, prices
are higher, varying from $9 in Chongqing to $12.50 in Beijing
and $16 in Shanghai in 2011.

This is far above U.S. wholesale prices and
comparable to prices paid by many customers in western Europe.

But most are set on a cost-plus basis, and the industry is
infested with cross-subsidies. Industrial users subsidise
residential customers. High rates of return on pipelines
subsidise low well-head prices. There is no mechanism for
recovering the cost of storage.

Regulated gas prices are well above the cost of finding and
developing conventional domestic gas fields but fall short of
the level needed to pay for imported LNG and may not be enough
to cover the higher costs of shale gas.

Nor is gas priced competitively with the major alternatives:
coal, fuel oil and propane/butane (LPG). In 2012 the government
launched a pilot programme linking local gas prices to a 60:40
basket of fuel oil and LPG, but so far it operates only in the
southern coastal provinces of Guangdong and Guangxi.

IEA warned that the government must take a view on whether
to pursue a market approach based on indexation to alternative
fuels or move to a hub-based pricing system, based on experience
with the limited hub in Shanghai.

It urged the government to liberalise prices for large
industrial users and gradually raise prices for residential
customers.

Companies need proper incentives (higher prices, better
market access and regulatory certainty) to make investments in
the domestic upstream. And the country needs to foster more
development of transmission and storage capacity while finding
ways to improve third-party access and develop a competitive
wholesale market.

None of this will be easy. The IEA appears to prefer a
market-based system based on the experience of the United
States, the United Kingdom and some other member countries,
though it is not clear this would be the right model for China
at this stage, and it will be bitterly opposed by the Big Three.

But whatever route the government chooses, there is an
urgent need for more stable regulation, clearer pricing and
stronger incentives for investment in exploration and storage if
the gas market is to live up to the government's ambitious
targets.

Next In Market News

WASHINGTON, Dec 9 Aetna Inc's chief
executive denied on Friday that its withdrawal from some
Obamacare exchanges was in retaliation for government efforts to
halt its merger with Humana Inc, as he sought to
convince a federal judge to approve the deal.

LOS ANGELES, Dec 9 President-elect Donald Trump
will remain an executive producer on the reality TV show
"Celebrity Apprentice," new host Arnold Schwarzenegger said on
Friday, defending the situation as similar to his own
transitions between politics and entertainment.

WASHINGTON, Dec 9 The U.S. Senate was preparing
to pass a government spending bill on Friday evening after
Democrats from coal states announced they would not risk a
government shutdown by continuing to delay the vote.

Reuters is the news and media division of Thomson Reuters. Thomson Reuters is the world's largest international multimedia news agency, providing investing news, world news, business news, technology news, headline news, small business news, news alerts, personal finance, stock market, and mutual funds information available on Reuters.com, video, mobile, and interactive television platforms. Learn more about Thomson Reuters products: